Hardship withdrawal - grossed up for taxes

I understand that (1) hardships can be used to purchase a primary residence, (2) hardship withdrawal amounts can be grossed up for taxes and penalties and (3) withholding is optional.

I have a hardship withdrawal on my desk with a Good Faith Estimate indicating that the ee needs to bring $5,480 to home purchase closing. The participant is requesting $8,000 with no withholding. The client is looking to me to bless the amount needed to satisfy the "immediate financial burden". Since no one really knows the tax liability, i.e. tax rate, until the end of the year (except the rich folks, of course) is there any guidance from IRS on the appropriate tax rate to assume when grossing up the hardship distribution for taxes and penalties? I am inclined to recommend 15% plus 10% which would put the actual hardship distribution amount at $7306.67, but I really have no basis for that thinking.

Also, not that I want to make up rules, but it doesn't seem logical that an employee can elect to have the distribution grossed up for taxes and penalties, then turn around and also elect no withholding. Of course, logic is not law or guidance for that matter!

Our form for our clients includes this: "Your request may include an additional amount to cover anticipated tax liability associated with this withdrawal. Your employer may require evidence to support this additional amount. "

Thanks, Brian. Living in Florida, I never think about state taxes. This guy lives in Arizona; I have no idea if they have a state income tax or not.

He makes around $50K. But I have no clue about other income or deductions.

Are you saying that you would gross up the amount....25% for taxes plus 10% for the penalty to arrive at $8430 and therefore process the hardship at the original $8,000 he requested?

I normally wouldn't belabor such a silly thing as this, but I've been dealing with IRS and DOL auditors lately and it seems my clients are having to justify at great length every tiny thing they do upon audit.

Instead of guessing, could the participant have insight on what their marginal rate will be (as long as it sounds reasonable, I'd use it)?

Arizona state taxes run from about 3% to 5% marginal rates. (Also note that some states follow the feds with their 10% early distribution tax; for example Wis uses, or once used, an extra 3%. I don't know what Arizona does.)

In response to your question about the oddity of no withholding, I see absolutely nothing problematic about that. You don't know what the person's existing withholding looks like -- it could be based on not having home deductions and they may not want to be overwithheld once they have the larger deductions in place. Withholding and tax liability are two very separate issues. As long as the person has the right to not withhold, their invoking that right shouldn't have any bearing on what you do.

I have never interpreted the "gross up for taxes" as being for the long run. I always thought this rule dealt more with the fact that you used to have to withhold 20% from hardships. However, I can see how you could it interpret it that way. Just wanted to bring that up for discussion. Any comments?

Had the participant simply come in requesting $8,000 for the home closing, would you have granted it?
My point is how do you know whether other requests have included a gross up or not? Do you require substantiation of the amount if there's no mention of a gross up? Or did you just stumble across the fact the amount was grossed up?
Finally, what's the harm in asking the participant to simply provide a written statement that the difference represents his calculation of his estimated federal, state and local taxes plus the federal 10% early withdrawal penalty and any other state penalty?

Gregory--the very first post said that the estiimate was for $5480. There's no guessing on the immediate need, just the "gross up".

Joel--in 401(k) plans: for 401k deferrals, only contributions may be taken. If the plan allows for other sources (such as match or profit sharing) contributions and earnings may be taken. It's all up to the plan document.

Remember: two wrongs don't make a right, but three rights make a left.